Whitepaper
Alpha Vaults was built using an LP Strategy calling Passive Rebalancing
Passive Rebalancing was introduced by Charm on 3rd May 2021, and quickly became one of the most frequently used strategy to manage liquidity. The strategy does not use swaps, and relies entirely on changes in the market price to manage liquidity.
The strategy's ability to Concentrate Liquidity, increase Capital Efficiency, and improve performance was proven during 2+ years of continuous operation on Mainnet.
The strategy improves performance by receiving (rather than paying) swap fees, avoiding price impact, and avoiding MEV extraction.
The strategy's open, transparent, and rules-based nature allows liquidity to be managed on-chain, and for passive investment vehicles to be created for LPs. These vehicles are called Passive Vaults.
Alpha Vaults offers a simple way to earn yields and manage liquidity using Passive Rebalancing.
Why are LP strategies needed?
Managing liquidity on Uniswap V3 can be difficult. For example, if LPs deposit $1000 of ETH and $1000 of USDC and the price moves, their position will no longer be balanced in a 50:50 ratio, which means they may not earn Fee Income, and have a higher* risk of Capital Loss**.
To bring the positions back to a 50:50 ratio, LPs will have to Rebalance - i.e. remove liquidity from the old positions and redeposit it into new positions.
An LP Strategy determines how and when to Rebalance, so that when the price moves, LPs can continue to earn Fee Income at lower Capital Loss.
*Compared to a Full Range Strategy.
**Capital Loss is realised and unrealised Impermanent Loss. For simplicity, Capital Loss will be used inter-changeably with Impermanent Loss in this whitepaper.
Alpha Vault's LP Strategy takes a probabilistic approach to liquidity management.
Using the strategy, the expected value of the vault's inventory ratio is 50:50, which means in the long-run, LPs are expected to earn higher Fees Income at lower Capital Loss.
The strategy is called Passive Rebalancing.
Overview of Passive Rebalancing
Passive Rebalancing is an LP Strategy deployed on-chain to manage the liquidity within a liquidity pool, such as the ETH/USDC 0.05% pool on Uniswap V3. It has two main parameters:
Base Threshold (B)
Limit Threshold (L)
The thresholds maintain two Liquidity Positions:
A Base Order symmetric around the Update Price X, in the tick range [X-B, X+B]. This will deposit liquidity in a 50:50 ratio, and any token that are undeposited will be placed as a limit order. This order increases the likelihood of higher Fee Income.
A Limit Order just above or below the the Update Price. It will be a single-token order in the tick range [X-L, X], or [X, X+L], depending on which token is undeposited. This order reduces the likelihood of Capital Loss.
Passive Rebalancing works by always trying to sell the asset causing the vault's inventory ratio to depart from 50:50, so that over time, the ratio will converge toward 50:50 as the Market Price changes. This is the key mechanism used by Alpha Vaults to lower impermanent loss.
Passive Rebalancing do not use swaps, and only relies on changes in the market price to get back to a 50:50 ratio.
This improves performance by collecting (rather than paying) swap fees, avoiding price impact, and avoiding MEV extraction.
Some numerical examples of Passive Rebalancing are provided below.
Example 1 - Vault has excess USDC
Assuming the vault manages liquidity for a USDC/ETH pool, and Rebalances when the Market Price of ETH in USDC is 150 ticks. The Update Price will be 150, and if B = 50 and L = 20, the range [100, 200] will be chosen as the base order, and [130, 150] as the limit order.
Assuming the vault manages 1 ETH and 160 USDC in total just before Rebalance.
At Rebalance:
The vault will deposit 1 ETH and 150 USDC into the Base Order, with 10 USDC left over.
It will deposit 10 USDC into the Limit Order.
If the Market Price decrease from 150 ticks, the 10 USDC will be sold to ETH and the vault will get closer to a 50:50 ratio.
If the Market Price increase from 150 ticks, more ETH will be converted to USDC, and the vault will attempt to sell even more USDC at the next Rebalance.
Steps 1 to 4 will be repeated at each rebalance until the vault gets to a 50:50 ratio, or if the vault has excess ETH.
Example 2 - Vault has excess ETH
Assuming the vault Rebalances when the Market Price is 180 ticks. The Update Price will be 180, and if B and L remain the same, the range [130, 230] will be chosen as the Base Order, and [180, 200] as the Limit Order.
Assuming the vault holds 1.2 ETH and 90 USDC just before Rebalance.
At Rebalance:
The Strategy will deposit 0.5 ETH and 90 USDC into the Base Order, with 0.7 ETH left over.
It will deposit 0.7 ETH into a Limit Order between [180, 200].
If the market price increase from 180 ticks at the next Rebalance, the 0.7 ETH will be sold to USDC and the vault will get closer to a 50:50 ratio.
If the market price decreases from 180 ticks, more USDC will be converted to ETH, and the vault will attempt to sell even more ETH at the next Rebalances.
Steps 1 to 4 will be repeated until the vault gets to a 50:50 ratio, or if the vault has excess USDC.
Implications
Alpha Vault's LP Strategy is open-source, decentralized, and executed using a transparent set of rules. This means liquidity can be managed on-chain, and passive investment vehicles can be created for Liquidity Providers (LP). These passive investment vehicles are called Passive Vaults:
Passive Vaults are investment vehicles that earns income from an open-source, transparent, and rules-based LP Strategy.
The following summarises the relationships between the Passive Vaults created by Alpha Vaults and other types of passive investments:
| Passive Investment | Passive Vaults | |
|---|---|---|
Example | ||
Investment View | Equity value will increase | DeFi trading volume will increase |
Investment Methodology | ||
Transparency | Complete transparency |
By investing in a Passive Vault created by Alpha Vaults, investors can express the view that DeFi trading volumes will increase, without having to actively manage the liquidity themselves.
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